Making Sense of Your 401(k) Investment Options

In recent years, the rising popularity of 401(k) plans has been astounding. Today, a large number of public and private entities offer these benefit plans to employees who are attracted to the ability to make pre-tax contributions. Eighty percent of eligible employees have balances in their 401(k) plans, and company contributions to these plans average 2.8 percent of pay.*

Most plans now provide participants with a variety of diversified investment options, offering an average of 15 funds for participant contributions,* so our investment options selection has become more complicated than ever.

Decisions, decisions

It's important to choose your 401(k) investments wisely. Generally, this can be achieved by carefully analyzing your options and your investment personality before you make any final investment choices.

The vital issues that come into play generally revolve around three basic factors:

• Your age and the number of years before you will need to make use of the investment options—also known as your "time horizon."
• Your ability to accept investment risk—commonly referred to as your "risk tolerance."
• Inflation, which has an eroding effect on all investments over time.

Combining these three factors with the concept of asset allocation can be extremely helpful, as well. This method divides investment funds into specific categories—generally, equities (stocks or stock mutual funds) and fixed income securities (bonds or bond mutual funds).

For instance, if retirement is close by, say 5 years away or less, a more conservative approach is often used. Under these conditions, up to 70 percent of your investment portfolio may be targeted to fixed return investments and 30 percent to stock. On the other hand, suppose retirement is 5-10 years away. In this case, you may wish to pursue moderate growth and moderate preservation of capital. A more balanced approach would be perhaps 40 percent going to fixed income securities and 60 percent going to stock. If you have more than 10 years until retirement, you might consider choosing more growth-oriented investments and place up to 85 percent of your portfolio in stock and only 15 percent in fixed-return investments. The above percentages may be modified to take into consideration your overall investment goals and your tolerance for risk.

Don't put your eggs in one basket

Once you've decided on your asset allocation mix (based on your time horizon), it's time to diversify your investments within each category. Because your 401(k) offers several investment options, you can pick and choose which option(s) best fit your tolerance for risk.

For example, suppose your retirement is 20 years away and you decide to allocate 85 percent of your contributions to stocks. As you review your plan’s available investment choices, you notice there are six different stock options from which to choose. Each stock option has its own unique characteristics, with different objectives and varying levels of risk associated with it. However, most investments can be grouped into Asset Categories with similar characteristics and management styles. Common descriptions are:

• Short-term/stable value - Short-term investments are generally cash and money market instruments; stable value investments typically offer investors a fixed rate of return and a guarantee of principal and interest for a defined period. (Fidelity Retire Money Market)

• Fixed income – Bonds or other debt obligations from companies or government agencies, which pay fixed rates of interest typically higher than short-term instruments. (Fidelity Government Income, Fidelity U.S. Bond, Blended Fund, Stated Return)
• Lifestyle/asset allocation – This category blends investments from among stocks, bonds and cash into one account or fund. Portfolio managers then “manage” the account or fund by purchasing and selling investments in each asset class within stated guidelines. The managers also will vary the mix according to market conditions. (Fidelity Asset Manager: Growth, Income, Balanced)
• Large cap value – More conservative stocks of well-established, large companies, they typically sell at prices that are low relative to their perceived value. (Fidelity Equity Income)
• Large cap core – Investments in this category usually contain a mixture of value and growth stocks, or they may contain stocks exhibiting both value and growth qualities. Their portfolios tend to exhibit middle-of-the-road characteristics when compared to portfolios emphasizing exclusively value or growth stocks. (Fidelity Magellan)
• Large cap growth – This category includes stocks whose prices are expected to rise. Intended as long-term investments, these stocks offer higher return potential in periods in which the stock market is flourishing. Large growth companies typically have capitalization exceeding $5 billion. (Fidelity Growth, Fidelity OTC)
• Small/mid cap value – These stocks are of companies with small to mid-range capitalizations that are selling at low prices relative to other stock companies of the same size range.
• Small/mid cap growth – This category includes stocks of companies in “mid-cap” (capitalization between $1-5 billion) or “small-cap” (capitalization less than $1 billion) whose prices are expected to rise. (Fidelity OTC)
• International/global – Foreign stocks, International/global choices are typically used to diversify a portfolio and tend to be more risky. (Fidelity Overseas)

By selecting several options that match your tolerance for risk, rather than just one, you can help minimize your overall risk from loss in the event that one under performs.

Remember…the choice is yours

The preferred path for any 401(k) investment plan is for you to objectively study the investments offered by your employer. A financial advisor also can assist in sorting through your 401(k) investment options. Only in this way can you evaluate all criteria and make meaningful, long-term decisions.

*Statistics taken from the Profit Sharing/401(k) Council of America’s Web site (www.psca.org), “PSCA Releases 46 th Annual Survey of Profit Sharing and 401(k) Plans: New Survey helps plan sponsors benchmark and shows industry trends.” Sept. 15, 2003.

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